Saturday, February 25, 2012

Cogito, Ergo Whom?

I'll be damned if I sign up for five years as CEO with less than 12% of the equity.
Carlyle Group said Wednesday, Jan. 31, it reached a definitive agreement to acquire Philosophy Inc., a fast-growing brand of lotions and personal-care products, for an undisclosed sum.

The Phoenix-based company generates about $50 million in Ebitda and had been expected to sell for about $450 milion, according to investment banking sources.


New York, February 1, 2007: The deal announced yesterday between private equity behemoth The Carlyle Group and Philosophy Inc. has kicked off a whirlwind of dealmaking and jockeying for position among leading private equity players in the fast-moving and lucrative philosophy sector. Mega-firms such as KKR, Apollo Management, and Texas Pacific Group are each rumored to be hiring dozens of industry experts and practitioners to build sector teams focused on finding investments in the industry.

“I haven’t seen anything like it since the panic to get into infrastructure last year,” claimed one senior private equity professional. “It’s insane.” Leading practitioners like Jerry Fodor of Rutgers University and Stanley Fish of Florida International University in Miami are rumored to be negotiating with competing financial sponsors to join as Philosopher-Executives-in-Residence for multi-year pay packages in excess of eight figures. Neither professor returned phone calls before press time, and officials at both universities refused comment.

The hiring frenzy has extended to less well-known industry participants also, as PE firms look to snap up junior resources with scarce industry knowledge and experience. Marvin Applestein, a third-year PhD candidate in philosophy at Harvard University, reported that he had heard of Assistant Professors specializing in esoteric fields like quantum epistemology being offered million dollar signing bonuses. “Even post-docs are getting in on the action. I’ve heard the Ferrari dealership in Cambridge is completely sold out,” he said.

The fever is apparently reaching across the pond to Europe as well. “I can’t talk now,” the head of Cambridge University Press’s Philosophy Section, Graham Smythe-Withers, commented earlier today, “Those bastards at Permira just swooped in and nicked my entire editorial staff, including the PAs!” Reached at a Heidegger colloquium at the University of Köln late yesterday, Permira Managing Partner Damon Buffini declined to comment. “It’s getting so bad, my friend Rudy at the Sorbonne tells me market demand for Sartre scholars might even resuscitate,” claimed Mr. Applestein.

“It’s no surprise that financial sponsors are finally taking a serious look at this industry,” commented Ralph Thomas, Senior Equity Research Analyst for Philosophy and Argumentation at Lehman Brothers in New York. “We have been bullish on this space for some time now.” Mr. Thomas notes that revenues and earnings have been climbing for most industry participants well in excess of 15% per year for the past five years, while earnings multiples for listed philosophy companies have failed to keep pace with the overall market. “We like a number of players, including large-cap companies like Kant AG and Descartes SA and mid-market participants Wittgenstein & Co. and Hume plc.” (Lehman Brothers does not provide investment banking services to any of these companies, and Mr. Thomas does not own shares in any of them, although he did take a course in Hegel once.)

“You can see why we’re all excited,” commented a senior partner at an un-named PE firm which is building its sector capability and looking for deals. “Dave [Rubenstein of The Carlyle Group] really snagged a sweet deal with Philosophy Inc. at nine times [EBITDA, or earnings before interest, taxes, disputation, and argumentation]. We would have been all over that deal, if we had had the resources two months ago.” The un-named partner noted that leveraged buyouts of philosophy companies, which primarily produce intangible assets, would have been extremely hard to finance just two years ago, due to traditional lenders’ unwillingness to lend against post-deal balance sheets consisting primarily of goodwill, free will, and radical skepticism. “Nowadays, I’ve got Stevie [Cohen, of hedge fund SAC Capital] on the phone every day, begging to lend me money for any ontology or metaphysics assets we can find.” Final details of Carlyle’s purchase of Philosophy Inc. cannot be confirmed, but preliminary reports indicate that selling advisor Houlihan Lokey offered potential purchasers stapled financing at seven times EBITDA.

Investment banks have seen the light, as well. Leading players such as Goldman Sachs, UBS, and Credit Suisse are currently in the process of building dedicated industry coverage teams focused on the philosophy sector in order to satisfy the booming demand for buy- and sell-side advice from corporations and private equity firms. “We are in the process of reallocating coverage bankers from the Healthcare and Consumer sectors into our Global Philosophy Group,” claimed Ken Moelis, President of UBS Investment Bank. “Given our strong lending capabilities and deep industry knowledge of Continental and Analytical Philosophy, we expect to become the leading advisor to corporations and financial sponsors in the space within the next 18 months.”

Some of his competitors beg to differ. “I sat in the same Michael Dummett seminar as Kenny when we were at Wharton, and let me tell you, Kenny may know his DCF [discounted cash flow], but he doesn’t have a clue about referential empiricism,” asserts Lloyd Blankfein, Chairman and CEO of Goldman Sachs.

For now, some market watchers say the safest bet may be to invest in the companies that sell picks and shovels to the miners of this new Gold Rush. Stacey Williams, Assistant Store Manager at the Barnes & Noble bookstore on Wall Street, reports that the store’s entire stock of Kierkegaard has been sold out for weeks. “Last week, a Columbia Business School professor brought his Advanced Accounting class of MBAs into the store just to show them where the Western Philosophy section was. It was kind of sweet. Most of those students hadn’t seen a humanities book since freshman year in college.”

NOTE, February 25, 2012: This crack piece of financial reportage was originally published on this site February 1, 2007. It has been slightly revised and rereleased for historical interest. Carlyle subsequently sold Philosophy Inc. for a profit, Lehman Brothers went out of business, and Ken Moelis left UBS to found an eponymous advisory firm. To the best of this reporter’s knowledge, David Rubenstein, Damon Buffini, and Lloyd Blankfein remain gainfully employed at their respective establishments. Subsequent to the feverish activity detailed in the original piece, the private market for philosophy assets collapsed back into its habitual desuetude, primarily due to European and American investors’ inability to agree on fundamental value. After failing to land a position at a private equity shop, Marvin Applestein departed the field of philosophy to become the 25th employee of an obscure start-up named Facebook, founded by another Harvard dropout. Mr. Applestein is currently looking forward to the imminent purchase of six Ferraris, each in a different color. Plus ça change...

© 2007, 2012 The Epicurean Dealmaker. All rights reserved.

Monday, February 20, 2012

Kindle This

Talisman of experience
And what is the faculty in man to which imitation is addressed?
What do you mean?
I will explain: The body which is large when seen near, appears small when seen at a distance?
And the same object appears straight when looked at out of the water, and crooked when in the water; and the concave becomes convex, owing to the illusion about colours to which the sight is liable. Thus every sort of confusion is revealed within us; and this is that weakness of the human mind on which the art of conjuring and of deceiving by light and shadow and other ingenious devices imposes, having an effect upon us like magic.

Plato, The Republic, Book X, Trans. Benjamin Jowett

Let it be rightly understood at the outset, Dear Readers, that I love books. Not just reading, not just literature: books. You remember: those physical objects fashioned out of paper, ink, glue, and board which have served as portable, semi-permanent delivery vehicles for all sorts of writing for hundreds of years. I have hundreds and hundreds of books at home; filed vertically on shelves, stacked horizontally on floors, and teetering menacingly on almost every flat surface near to hand. Mrs. Dealmaker used to complain about my compulsion, but then she succumbed to her own form of the disease. Now our read and unread books face off against each other in competing piles across the master bedroom floor. We have lots of books.

That being said, I do not qualify as a book collector in the usual sense. I have little interest in first editions, rare antique books, or expensively bound limited editions. I couldn’t care less if the author of a work autographed the frontispiece. Leather and calf bindings bore me. I am not a fetishist of books-as-valuable-objects. No, what I seek out are books which have two key criteria: content which interests me and an aesthetically pleasing design. This does not mean they must be hardcovers; in fact, by number I now own far more paperback books than hardbound. But in order for me to lay down my ill-gotten gains on a book, it must have content I reasonably expect to find challenging, interesting, and/or entertaining for more than one reading, and it must be published in a form which will not nauseate me to gaze upon. These two criteria, you may or may not be surprised to learn, prove a remarkably effective prophylactic against spendthrift behavior when I visit the average bookstore or online book vendor.

To date, I have not succumbed to the siren call of a Kindle, iPad, or other form of e-reader. I have nothing against the devices, which combine several features and conveniences which I find intriguing. The most important of which, I must say, is the ability to carry dozens if not hundreds of books in one lightweight, portable package. Given how many books I start and put down, and how many I have in various stages of reading at any one time, such a device might be a convenient alternative to my current travel routine, which normally boils down to a choice between dislocating my shoulder by lugging four or five hardcovers and paperbacks in my carryon or being reduced to leafing through the SkyMall catalog when I run out of business reading. It might also boost my consumption of newly released fiction and non-fiction, which I currently avoid because I have no interest in spending $39.95 on shoddily produced, crappily designed hardcover works which I have every expectation and intention of throwing in the trash as soon as I have finished them. (Did I mention that I think 99% of books published today aren’t worth the energy it will take to pulp their remainders?)

* * *

All of which is exculpatory preamble to a few remarks I wish to make in response to Tim Parks’ recent paean to e-readers in, of all places, The New York Review of Books. Mr. Parks does a creditable and evenhanded job enumerating the pros and cons of e-readers versus traditional books,1 but he is not content to suggest that old habits of reading and a slightly suspect fetishism around books-as-objects are tolerable losses in the face of the new medium’s conveniences. No, he contends that e-readers are better for literature:

Literature is made up of words. They can be spoken or written. If spoken, volume and speed and accent can vary. If written, the words can appear in this or that type-face on any material, with any impagination. Joyce is as much Joyce in Baskerville as in Times New Roman. And we can read these words at any speed, interrupt our reading as frequently as we choose. Somebody who reads Ulysses in two weeks hasn’t read it any more or less than someone who reads it in three months, or three years.

Only the sequence of the words must remain inviolate. We can change everything about a text but the words themselves and the order they appear in. The literary experience does not lie in any one moment of perception, or any physical contact with a material object (even less in the “possession” of handsome masterpieces lined up on our bookshelves), but in the movement of the mind through a sequence of words from beginning to end. More than any other art form it is pure mental material, as close as one can get to thought itself. ...

The e-book, by eliminating all variations in the appearance and weight of the material object we hold in our hand and by discouraging anything but our focus on where we are in the sequence of words (the page once read disappears, the page to come has yet to appear) would seem to bring us closer than the paper book to the essence of the literary experience. Certainly it offers a more austere, direct engagement with the words appearing before us and disappearing behind us than the traditional paper book offers, giving no fetishistic gratification as we cover our walls with famous names. It is as if one had been freed from everything extraneous and distracting surrounding the text to focus on the pleasure of the words themselves. In this sense the passage from paper to e-book is not unlike the moment when we passed from illustrated children’s books to the adult version of the page that is only text. This is a medium for grown-ups.

Put aside, for a moment, Mr. Parks’ schoolboy aesthetics. Literature is more “mental material” than any other art form? Really? More than music (auditory), painting (visual), dance (kinesthetic)? Put aside his breathtakingly simplistic view of cognitive psychology. Does he really think our conscious minds function in a coherent, linear, narrative way using and reproducible by formal language? I don’t know about Mr. Parks, but I’ve tried to observe myself in thought many times and under many conditions over the years. For what it’s worth, there is nothing about my conscious thought that remotely resembles the literature of Tolstoy, Joyce, or even Danielle Steel. (I won’t even address my unconscious thought.) Everything we are beginning to learn about how humans think supports this view: conscious thought is nothing like literature. That’s part of the reason we like literature so much, in my opinion: it flatters us not only that our lives make much more sense than they do but also that we are much more in control of our thought processes than we really are.

* * *

No, my real objection to Mr. Parks’ argument has to do with the naive Platonism he attempts to sell us. His entire argument seems to boil down to the assertion that there is some sort of “pure text” at the base of every work of literature—words in inviolate sequence, to use his coinage—and that e-readers, by collapsing and standardizing our access to them, somehow make our experience of literature purer and more authentic. But this is just bullshit. The experience of literature—and reading in general—is always and everywhere a solitary interpretative act on behalf of and by the reader. Readers read literature in time, in space, and through some sort of medium. Time spent reading—pace, duration, intervals when one puts down the book—directly and ineluctably affects the reader’s experience of the text. Readers who read Ulyssess in three years may indeed have read the same text as those who read it in two weeks, but they certainly have not had the same aesthetic and cognitive experience. In addition, solitary reading involves the visual faculties and aesthetic senses, too. Font, line leading, margins, and even pagination affect a reader’s experience of a text, often subconsciously. No-one who has ever compared a cheap, cramped, badly-typeset version of a novel to a well-designed, spaciously laid out one can help but notice the difference. And noticing the difference in and of itself alters the experience of the work. Joyce may be as much Joyce in Baskerville as in Times New Roman, but I dare you to find him the same author in twelve point Comic Sans.

A book, properly considered, is a recorded performance of a piece of literature, just like a CD is a recorded performance of a particular piece of music. While musicians have more artistic discretion in interpreting a piece than a book designer and publisher do, the latter are not aesthetically invisible. They subtly influence a book’s format and packaging: font, margins, page breaks, cover art, etc. The sequence, timing, pace, and even completion of the work—its interpretation—lie in the hands of a reader, but the packaging and presentation of the physical object is not. And because reading is a performance, the time and place where you read is important, too. Reading Lord Jim on a plane is not the same as reading it on a tropical beach. The former is forgettable; the latter is not, as I can personally attest.

Beethoven’s Ninth Symphony is the same music, whether it is interpreted by the Berlin Philharmonic or the Boise Symphony. But nobody ever hears Beethoven’s Ninth Symphony: they hear a performance of it. By the same token, nobody ever reads Ulysses, they read a version of it, as presented to them through the medium of some sort of delivery device at a particular time and place, and interpreted according to their own engagement, interest, aptitude, and sensitivity. A Kindle or an iPad is just another delivery device, constrained or liberated, as the case may be, by its technical and aesthetic capabilities and limitations. There are many texts where an e-reader’s ability to standardize, flatten, and minimize aesthetic variation may very well be an advantage. (I think in particular of current non-fiction, biography, history, and other trade books.) But to pretend it is therefore somehow more transparent to a work of literature than a physical book is wishful thinking.

* * *

Art is not art, in any meaningful sense of the word, if it is not interpreted by an audience. This is true of literature, too. Sure, there may be some ur-text which an author intended to publish when she wrote it, but that work cannot exist outside the physical, experiential world in which it is consumed by its readers. The same is true of painting, music, dance, or indeed any artistic medium. A shiny metal and glass tablet imposes an technological aesthetic on the works you read it with: uniform, limited, ephemeral. This may be just fine, and even preferable in certain instances. But don’t pretend reading Don Quixote on a Kindle is the same as reading it in a book. Those are two different artistic experiences. And neither one is any closer to the “true” nature of the work than the other.2

Eventually, Plato asserted, a thoughtful person may come to understand that the shadows on the wall of the cave are not the real objects making them. But even Plato knew that no-one can really free himself from his chains and turn to look at the fire.

Related reading:
Tim Parks, E-books Can’t Burn (The New York Review of Books, February 15, 2012)
Pixels Don’t Breathe (May 17, 2011)

1 Although he does rather embarrass himself in the last paragraph with naive technological utopianism. Every advantage he claims for e-readers there is either questionable, exaggerated, or untrue. I suspect e-readers burn rather nicely, given the proper fuel.
2 There is an affirmative case to be made for the superiority of a physical book, too. Given that one cannot separate the nature of the physical delivery mechanism from the experience of the underlying literature, why should one not try to enrich, gloss, and extend the aesthetic experience of the literature by enhancing the aesthetics of the mechanism? Taken to an extreme, this results in one-of-a-kind books which integrate bookmaking entirely into the artistic enterprise. In a mass-produced example, it can lead to works like Anne Carson’s facsimile of her handmade book, Nox, in which the experience of the text is inseparable from its resolutely physical embodiment. More commonly, it leads to books like my dog-eared copy of Penguin’s Lord Jim, which is a talisman of all the experiences I have had with that novel. It pleases me to look at it on the shelf, and this pleasure is itself a continuation of my literary engagement with Joseph Conrad’s creation. Try to cram all that in a wedge of plastic, glass, and metal.

© 2012 The Epicurean Dealmaker. All rights reserved.

Saturday, February 18, 2012

The Standard Model

Each building block has its place. Without one, the entire structure would fall.
No, no, no, no, no.

Now poor Ezra Klein has fallen into the instrumentalist trap of higher education. In an opinion piece on Bloomberg, Klein accuses Harvard and other elite institutions of higher education of failing their liberal arts students. He claims they neglect to provide their charges with sufficient opportunities to develop real-world, “marketable” skills. Accordingly, Harvard and its ilk
are producing a large number of very smart, completely confused graduates. Kids who have ample mental horsepower, incredible work ethics and no idea what to do next. So the finance industry takes advantage of that confusion, attracting students who never intended to work in finance but don’t have any better ideas about where to go.

Ay, and there’s the rub. For you see, Ezra is upset that so many poor, confused graduating seniors from Harvard, Princeton, and Yale are taking jobs in the big, bad finance industry, which we all know to be a seething cesspit of moral turpitude. Harvard paints a big, fat “EAT ME” on the backs of its innocent, unsuspecting seniors, and the Wall Street Wolf is only too happy to oblige.

It’s a neat, compelling story, perfectly in tune with the bankster-hating zeitgeist of our times: Evil financial Svengalis corrupting the (almost) virginal sons and daughters of the hardworking parents whose homes they repossessed, all with the tacit complicity of the selfsame institutions we entrusted to educate the flower of our youth.

Too bad it’s full of holes.

* * *

First, however, I must acknowledge that Mr. Klein accurately describes the approach which Wall Street and management consulting—the other major predator1 raiding the Career Services office of your average Ivy League university; one which typically takes the second largest share of graduates—employ to woo and win their prey:

It begins by mimicking the application process Harvard students have already grown comfortable with. “It’s doing a process that you’ve done a billion times before,” explains Dylan Matthews, a Harvard senior. “Everyone who goes to Harvard went hard on the college application process. Applying to Wall Street is much closer to that than applying anywhere else is. There are a handful of firms you really care about, they all have formal application processes that they walk you through, there’s a season when it all happens, all of them come to you and interview you where you live. Harvard students are really good at formal processes like that, and they’re less good at going on Monster or Craigslist and sorting through thousands of job listings from thousands of companies whose reputations they don’t know. Wall Street and consulting (and Teach for America, too) turn applying to jobs into applying to college, more or less.”

Yet that’s only half of it. A bigger draw, explained a recent Harvard graduate who majored in social science and worked at Goldman Sachs for two years, is how Wall Street sells itself to potential applicants: As a low-risk, high-return opportunity that they can try for a few years and, whether they like it or hate it, use to acquire real skills to build careers.

This is true: I admit it. We dastardly bankers and our evil management consulting cousins make it easy for students at elite colleges to apply for entry level positions. It’s almost like we want to compete for the brightest, most accomplished, hardest-working, most ambitious new entrants to the work force.2 Many of us having gone to such institutions ourselves, it can be no surprise that investment bankers and consultants have structured our recruiting efforts to ensnare as many likely candidates as possible from our alma maters. It’s also no surprise our sales pitch resonates with the little bleeders. Wall Street has built its business model to rely upon a steady stream of hard-working, ambitious, intelligent cannon fodder to do the heavy lifting. Is it any wonder we have pitched semi-permanent recruiting tents under the leafy groves of academe? Wall Street and the Ivy League are symbiotic.3

* * *

Having conceded Mr. Klein’s point that bankers are successful at luring many of our best and brightest to perdition, however, it is worth enumerating the reasons why the rest of us should not take the vapors over this enormity. First, hiring anywhere from 17 to 36% of top universities’ graduates into “finance” becomes far less alarming when one realizes we are talking about hundreds of benighted souls, not thousands or tens of thousands.4 Furthermore, the proportion of new hires to my industry coming from the highest-ranked schools (HYP, the Ivy League, Oxbridge, or wherever you personally wish to draw the line) is much higher than from the college graduate population in general. We do not hire a third of all college graduates. We just don’t have that many jobs. I suppose, in order to maintain an appropriate level of outrage after acknowledging this arithmetic fact, you must believe this small handful of elite schools has a monopoly or near monopoly on all the most intelligent, ambitious, hard-working, and potentially valuable young contributors to society. Having attended one of these outfits, and having interviewed and hired dozens if not hundreds of their students as well as students from “non-elite” schools over the years, I must strenuously disagree with you. I’ve said it before: Wall Street hires a type from among the best and brightest, but nowhere near all of them.

Second, the investment banking sales pitch is not snake oil: the financial analyst program which we hire new graduates into does indeed last for two years, and two years only. After that, most of the participants leave. In order to stay, you must want to stay, and we must want you to do so. This does not happen very often. Most analysts go off to graduate school, get jobs outside finance, or disappear from our radar entirely. Their indentured servitude is short, and we encourage the vast majority of them to reenter society, where they have every opportunity to serve their fellow man as they see fit. Given the kind of meat grinder we put them through, it is somewhat of a surprise to me that as many try to return after business school as do. The ones who do return must scrabble for a place on the slippery pyramid of Analyst, Associate, Vice President, Director, and Managing Director. Very few of us make it to the top or, once there, stay for long. It is an unadvertised fact about my vocation that few who enter investment banking enjoy what normal people would consider a full career. I have no facts at hand, but I would guess the average tenure in my business for professional positions is less than five years. If we do impress your babies into our despicable crime syndicate, mommies, we won’t hold them for long.

Third, and perhaps most interesting to me, I see fewer of the sort of befuddled, directionless soon-to-be-graduates coming from Ivy League or indeed any universities nowadays than Mr. Klein implies exist. Given what I know about the maturity of twenty-two year olds, and the relatively common realization among college seniors that the all-consuming goal toward which they have been slaving for three-quarters of their young lives—a sheepskin from HarYaleOxCambTon—is nigh upon them, I am surprised so few show up for interviews in a catatonic state. Rather, I see a level of professionalism, independent study, preparation, and sheer careerism among investment bank interviewees that is downright frightening. Even the Brown senior who majored in Medieval French Poetry and minored in Latin American Political Dance comes to the first interview having taken DCF modeling, Corporate Finance accounting, and Advanced Powerpoint Presentation classes from independent training firms who prep candidates for this very purpose. She had better, because the hard-core i-banker wannabes, who majored in Economics, have idolized Warren Buffett since grade school, and sleep in khaki pants and buttondown shirts are so numerous nowadays we just don’t need to hire the well-rounded, intelligent dilettantes. Those days are gone. Sure, some do get in—I wish we got more—but investment banking is no longer one of the leading candidates to hire them.5

So, even if we agree that Harvard and its peers are failing to shield liberal arts graduates from the evil banksters of Wall Street, I think we can acquit them of inflicting massive damage to society by it.

* * *

But more to the point, really, I disagree wholeheartedly with Mr. Klein’s premise. Why should a liberal arts education give marketable skills to its graduates? What is the point? There is a very good argument that a liberal arts education is a luxury consumption good in its own right. After striving for years to get into the “right” college, why shouldn’t a young person have the opportunity to explore learning and knowledge for its own sake, without thought for its future marketability? Plenty of college students nowadays—perhaps too many, in this old man’s opinion—spend all their time and energy in college acquiring what they believe to be marketable skills, without considering for a minute whether the employment to which they aspire is right for them, will exist in a meaningful form in the future, or even will hold their interest for more than a few years. How much better that some youngsters have the opportunity to reason undistractedly about history, art, philosophy, politics, and literature for a few, brief years before they have to worry about paying the rent.

From this Writer’s perspective, it’s a downright shame that investment banking cannot employ more liberal arts graduates than it does. Given that no-one else in society seems to be subsidizing this activity, I must admit a little pride that my colleagues and I can do as much as we do. It’s not like we are covering ourselves in glory elsewhere.

The rent will always be due. Jobs, firms, and professions will come and go. Markets, political systems, societies, and nations will flower, bloom, and sink into the sea.

Somebody, somewhere, should be thinking about bigger things.

Related reading:
Ezra Klein, Harvard’s Liberal-Arts Failure Is Wall Street’s Gain (Bloomberg, February 15, 2012)
Catherine Rampell, Out of Harvard, and Into Finance (The New York Times, December 21, 2011)
In the Nation’s Service (December 29, 2011)
Sovereign Triviality (November 19, 2011)

1 Management consulting? I ask you.
2 As measured and preselected for us by the vast social machinery leading up to, surrounding, and including elite undergraduate education at very little expense to us. Of course, bright, accomplished, hard-working, ambitious young people are not limited to soi-disant elite universities, by any means. But collecting so many of them in one place does make our search for new employees so much more efficient, wouldn’t you agree? Plus, investment bankers are not above exploiting the signaling value of an Ivy League education for ourselves, our competitors, and our clients. A lot of us went there, after all. We’ve drunk that Kool-Aid from birth, along with many (most?) of the rest of you.
3 Interestingly enough, however, it is often unclear which of us is the parasite and which the host.
4 Dastardly buggers that they are, the top schools do not break down what professions they actually include under the rubric “finance.” Given, however, that it normally includes commercial banking, insurance, buy-side investing, and real estate, you may assume that a much smaller portion of the advertised percentage actually gets to eat baby seal with the rest of us in investment bank cafeterias after graduation. Non-investment bank finance employers are welcome to defend themselves on their own dime, as I have no interest in doing so.
5 This is not to even mention the vast number of college graduates—even in the Ivy League—who school themselves in engineering, hard sciences and mathematics, computer science, journalism, business, and other fields with what I presume Mr. Klein would consider hard, marketable skills. Many of these apply for jobs in investment banking and consulting, too, and many get them.

© 2012 The Epicurean Dealmaker. All rights reserved.

Thursday, February 9, 2012

The Harrowing

Anselm Kiefer, Nigredo, 1984
“What’s in the box?”

“Pain.” He felt increased tingling in his hand, pressed his lips tightly together.
How could this be a test? he wondered. The tingling became an itch.

The old woman said: “You’ve heard of animals chewing off a leg to escape a trap? There’s an animal kind of trick. A human would remain in the trap, endure the pain, feigning death that he might kill the trapper and remove a threat to his kind.”

The itch became the faintest burning. “Why are you doing this?” he demanded.

“To determine if you’re human. Be silent.”

— Frank Herbert, Dune

According to Wikipedia,

Nigredo, or blackness, in alchemy means putrefaction or decomposition. The alchemists believed that as a first step in the pathway to the philosopher’s stone all alchemical ingredients had to be cleansed and cooked extensively to a uniform black matter.

In analytical psychology, the term became a metaphor “for the dark night of the soul, when an individual confronts the shadow within.”

Now is the winter of investment bankers’ discontent. The long foreshadowed harrowing of my industry, the great winnowing of its inhabitants, is underway. The huge, tottering edifice of proprietary trading, structured products, and bespoke derivatives, which suckled at the twin teats of Greenspan’s largesse and investors’ desperation for yield in the age of negative real rates, will suffer the greatest harm. But the rest of us—innocent or not of the worst offenses of our industry—will suffer the fallout, too. Pay will be slashed, jobs will be cut—never to return—and egos will be racked upon the callous indifference of executives and shareholders more concerned with their own personal trials and tribulations than the suffering of their bought-and-paid-for minions.

Our enemies will rejoice. Spiteful, envious souls will gnaw greedily on the bitter bones of schadenfreude in cramped and narrow defiles, sucking out the meager marrow to satisfy their self-righteous, operatic anger. Let them. Those humans among us who remain, who survive—and rest assured, Dear Friends, some of us will survive—will remember.

O yes, Dearly Beloved, we will remember. We will remember our friends and enemies. We shall never forget.

Enjoy the show.

© 2012 The Epicurean Dealmaker. All rights reserved.

Sunday, February 5, 2012

Apocalypse, Ciao!

Insure this
Francie Stevens: “I’ve never caught a jewel thief before! It’s stimulating! It’s like... It’s like...”
John Robie: “Like sitting in a hot tub?”

— To Catch A Thief

Part of the real pleasure of the interwebs for me, O Dearly Beloved, is the occasional opportunity Your Muddle-Headed Correspondent has to engage in a stimulating conversation with one or more individuals who are clearly more intelligent, better read, and cleverer arguers than Yours Truly. I tend to gain a lot from such interactions, if only a better understanding of my own opinions and the limitations of my knowledge and intelligence. They tend to generate a crush of sensations, including excitement, the sheer terror of discovery that I am out of my depth, and an urgent desire to land a couple of cheap shots on the champion before I scramble out of the ring to safety.

Today’s reflections are inspired by the response Carolyn Sissoko made to my recent post on unlimited liability in finance. While I am not equipped to address some of her points—especially on the topic of what she sees as the increasingly pernicious use of collateral by modern financial intermediaries—I would like to venture a few remarks and intuitions, in the spirit of a novice fighter taking a couple tentative jabs at Mike Tyson. Hopefully she will be gracious enough to let me run away thereafter.

First, Ms Sissoko uses historical evidence (what’s that?) to demonstrate that a regime of unlimited liability is not necessarily inconsistent with low required rates of return on capital:

The system of unlimited liability banking grew up in an environment with usury laws, so interest rates (on short-term debt) did not exceed 5% per annum. Market rates often fell as low as 2%. It’s far from clear that low interest rates for borrowers are inconsistent with unlimited liability on the part of lenders who choose to use their ability to borrow to leverage their returns (i.e. to act as partial reserve banks).
But I think this point misses the thrust of my previous argument. My intuition about unlimited liability is that capital providers subject to it have a natural limit to the amount of credit they are willing to extend regardless of price. Each lender sets her individual limit based on her estimation of the likelihood of loss beyond initial capital invested. Beyond that there is no price at which she would be willing to lend. This certainly would be my preference: if I faced the loss of my home and possessions, penury, and utter ruination, you can damn well be sure I would not extend just one more loan to capture an extra fifty, hundred, or even thousand basis points of yield. I do not think I am alone among heartless, flinty-eyed rentiers in this regard. The historical evidence Andrew Haldane cites from early 19th century Britain is entirely consistent with this: compared to the situation today, banks were massively overequitized and highly liquid, and bank assets and hence lending were a very low proportion of the economy. If my intuition is correct, it may well be that prevailing market rates of interest during that period evidence less that capital was plentiful and demand fully satisfied and more that supply and demand were balanced in a regime of artificially limited supply. Certainly Mr. Haldane contends—based upon what, I do not know—that the system of unlimited liability was not capable of supplying the growing need for capital during the rapid industrialization of the mid 19th century.

I strongly suspect that if we attempted to reimpose a regime of unlimited liability on capital providers nowadays, the pool of capital available to the economy would shrink, and likely dramatically. People with capital would simply become unwilling to lend to or invest in risky projects beyond a certain point, and the evidence from 19th century Western industrial societies seems to indicate that point would be at a dramatically lower level than we have become used to over the past 70 years. Unlimited liability could well be massively contractionary. This, I assume we all can agree, would not be a good thing.

* * *

Second, Ms Sissoko rather loses me when she asserts that

from a theoretic point of view, a banking system doesn’t need capital, it needs trust (aka credit). If the institutional framework is carefully structured (that is, debts are enforceable, outright fraud is disincentivized/rare, etc.) there is no shortage of capital — capital is created out of thin air by a plethora of unsecured, but trustworthy, promises. Effectively, capital is cheap, because the institutional structure of finance reduces the risk of losses to a minimum.

It may be that the intestinal parasite (me) within the dinosaur simply cannot conceive of a world without dinosaurs or dinosaur intestines, but I don’t get this. Capital is, in my understanding, at base a buffer against loss. Perhaps capital and bank lending vanishes when you sum all of its offsetting accounts across the entire economy, but capital serves a very important protective function at the “local” level of real creditors and borrowers. Capital absorbs loss, and either stops or slows the propagation of that loss through the daisy chain of economic interrelationships economic actors maintain. It is like the collapsible drums filled with water at the top of a freeway exit, whose function is to slow or impede the destructive progress of a runaway car. Sure, a runaway car will eventually stop of its own accord due to friction and gravity—if not another car or building—but do we really want to conclude from this that crash drums aren’t desireable or necessary?

I presume Ms Sissoko would counter that, with appropriate care and attention, we could design freeways and perhaps even cars so that we need not worry about collisions or runaways, but I fear that implies a level of omniscience—and systemic rigidity—which I find hard to credit. Financial loss is triggered both endogenously and exogenously. Being unable to anticipate all the ways financial loss can occur and directions from which it can come, I would much prefer to have various pools of capital sitting around the system, hopefully helpfully positioned between me and disaster. Besides, without capital, how can we enforce incentives? Capital belongs to someone. I thought the point was to reduce unnecessary systemic risk by presenting those positioned to create the risk of loss in the first place with incentives not to do so recklessly. How else can we do this except by making them the first to bear that loss; i.e., lose their capital?

* * *

One of the most pernicious effects, in my opinion, of the evolution of limited liability in the financial system, and the consequent transfer of more and more tail risk to society at large, has been the weakening of our understanding of the price of risk. Now don’t kid yourself: society always stands as the loss-absorber of last resort, under any capital, economic, or financial regime, because there are some losses which are too large for any system to absorb. (Think about a kilometer-wide asteroid hitting New York City or Los Angeles, for example.) After all, financial losses happen to a society. But the drawback of risk assumed by government and taxpayers is that it is not explicitly priced. Leading up to the recent financial crisis, as financial actors’ capital at risk shrank and society assumed ever more tail risk, more and more of the spectrum of possible financial loss fell outside the capital markets’ risk pricing mechanisms. Risk, whether from risky investment projects, financial leverage, or whatnot, looked cheap because an increasing portion of it was not being priced. We all levered up and engaged in riskier activities because we thought those activities had somehow got less risky. Remember the “Great Moderation?” It turns out instead we were just hiding a lot of potential loss out of sight, in the Grandma’s attic of a taxpayer backstop.

I continue to maintain two important things about financial risk. First, that it is incompressible; that is, a certain level of risk is ineluctably tied to the pursuit of a particular level of returns. No matter how you slice it, you cannot reduce the risk associated with a certain return. If it looks like risk is lower than you anticipated based on past history, rest assured it has not declined. You have either transferred it to someone else (e.g., through derivatives, in which case you have transferred some of your return, as well), or you have just lost track of some of it (perhaps by shifting it onto taxpayers). Second, that the risk-return relationship obtains at a society-wide level, as well. It may very well be the case that we unknowingly assumed more risk than we are comfortable with as a society, because we lost track of some of it by shifting it outside the financial markets, unpriced, onto our own backs. We pursued a growth and consumption agenda that was a lot riskier, in retrospect, than we believed at the time. But lowering the risk of loss we are willing to accept as a society will have ironclad implications on the types of returns we enjoy.

Surely there is a happy medium between a low-growth, capital-constrained economy hobbled by unlimited liability to capital providers and the reckless bacchanal we financed with “other” people’s money up to the financial crisis.1 But make no mistake, the decisions we make about how we allocate, limit, and distribute financial risk throughout society—including how much to put financial intermediaries on the hook—will reverberate broadly through the system and ultimately affect our very living standards and prospects:

So part of the conversation we continue not to have in the public domain is what kind of returns—in the broadest sense—we desire for our economy and society, and therefore what level of risk we are willing to tolerate. Sure, we could turn the entire banking industry into a regulated utility, with mandated minimum equity levels, maximum allowed returns on equity, and limits on institutional size and interconnectedness (assuming we can understand, monitor, and control such parameters, which may be a slightly heroic assumption). But what knock-on effects would that have on investors, on businesses in search of risk capital for their growth projects, on consumers, and on the economy at large? Dampen the incentives and ability of financial intermediaries to originate, take on, and distribute investment risk, and it is not clear to me that overall risk-taking (i.e., investment) in the economy will not go down. But if that happens, are we not explicitly or implicitly settling for less growth and fewer wealth creation opportunities in the economy overall? Is that really the outcome we are seeking?

By this, I do not mean to say our current system works well, or that the level of risk inherent in the financial system is appropriate or even efficiently distributed given our overall economic return objectives. But it does mean that we need to be a little more thorough, and a little more honest with ourselves and our opponents in debate, in thinking about the consequences of individual actions or “solutions” we advocate imposing on financial intermediaries. For consequences will flow inexorably in directions we do not—and perhaps even cannot—anticipate, and we will be remiss—and even no less irresponsible than the people who allowed the recent financial crisis to happen in the first place—if we do not make provision to address them.

But cheer up. Things could be a lot worse.

Related reading:
Carolyn Sissoko, A little fear is a good thing (Synthetic Assets, February 4, 2012)
The Blind Men and the Elephant (June 21, 2011)

1 Oops. I guess it was our money all along, after all.

© 2012 The Epicurean Dealmaker. All rights reserved.

Saturday, February 4, 2012

Leverage This

What's your collateral?
Jessie Stevens: “It was exciting at first, but you know now I think it’s more exciting to have them stolen.”
John Robie: “Yes, because you can’t lose financially as long as Hughson is around to make out the check.”
Jessie Stevens: “Well I’d be crazy to take this attitude if I did.”

— To Catch A Thief

I have had an absorbing day thinking about moral hazard, unlimited liability, and the modern financial system, O Dearest and Most Inquisitive of Readers. My thoughts have been guided by two intriguing articles; one, a blog post by Carolyn Sissoko at Synthetic Assets in response to Steve Randy Waldman’s recent pieces on opacity in finance, and two, a speech given by Andrew Haldane of the Bank of England last October. Both have enlightened me immeasurably about the long-term history of banking and finance, of which, I am mildly chagrined to admit, I have apparently been woefully ignorant. Such are the shortcomings of a Modern Man of Action.

Having little to recommend me as a guide to the fields of financial history or economics generally, I will spare you my amateurish glosses on each of these pieces, and encourage you instead to read them yourselves. Suffice it to say that I found their narratives of the transformation of banking and other financial intermediaries from their original state as small partnerships sharing unlimited liability to today’s limited liability corporations fascinating. For one thing, I was unaware of the common intermediate step, which obtained from roughly the second half of the 19th century through the 1930s, in which bank shareholders were subject to “extended liability,” which required them to put up additional (but not unlimited) capital in the event it was required to meet the bank’s obligations. While this system—and the unlimited liability regime which preceded it—did not prevent the occurrence of numerous bank runs and financial panics during this period, Ms Sissoko contends that it performed pretty well as a shock absorber for the financial system. Bank losses hit bank shareholders and partners first, often with the effect of bankrupting them, and depositors were able to recover their monies, albeit with notable delays. Naturally, as one might suspect, having liability in excess of direct capital invested encouraged an excess of caution among banks in the loans they underwrote.

Andrew Haldane explains:

Bank balance sheets were heavily cushioned. Equity capital often accounted for as much as a half of all liabilities, while cash and liquid securities frequently accounted for as much as 30% of banks’ assets. Banking was a low-concentration, low-leverage, high-liquidity business. A broadly-similar pattern was evident across banking systems in the United States and in Europe.

This governance and balance sheet structure was mutually compatible. Due to unlimited liability, control rights were exercised by investors whose personal wealth was literally on the line. That generated potent incentives to be prudent with depositors’ money. Nowhere was this better illustrated than in the asset and liability make-up of the balance sheet. The market, amorphously but effectively, exercised discipline.

It was given a helping hand by market-based prudential safeguards. Directors of a bank had the capacity to vet share transfers, excluding owners without sufficiently deep pockets to bear the risk. Shareholders also maintained their liability after the transfer of their shares. This put shareholders firmly on the hook, a hook they then used to hold in check managers. Managers monitored shareholders and shareholders managers. In this way, the 19th century banking model aligned risk-taking incentives.

Given the common diagnosis of the recent financial crisis as arising, at least in part, from excess risk taking by commercial and investment banks due to misaligned managerial incentives and the (ultimately correct) perception that society would step in to cover bank obligations during a panic, it is tempting to view such a regime as preferable to the one we have now.

But before we force Jamie Dimon to sell his houses and cars to stem a run on JP Morgan, it is important to understand why unlimited and even extended liability banking was replaced. According to Haldane, unlimited liability proved “rather too effective as a brake on risk-taking” and insufficient to the provision of credit in the face of increased societal demands for “capital to finance investment in infrastructure, including railways.” Society’s demand for growth investment began to outstrip the appetite of the wealthy to provide it. Subsequent solutions—first, to extend unlimited liability to a broader shareholder base, and second, to cap liability at two to three times the investor’s initial investment—merely compounded the problem, by bringing in investors without the financial resources to sustain periodic losses and exacerbating panics by calling capital from investors under duress. Banks and other financial intermediaries like investment banks consolidated as their economies grew, and the span of control problem inherent in vetting ever increasing shareholder bases became unmanageable. So, by the 1930s, our current system of large, limited liability financial institutions with dispersed and anonymous shareholder bases was largely in place.

* * *

The question I am left with is the following: given that historical precedent (and common sense) seems to indicate that restricting banking to those wealthy enough to sustain personal losses well in excess of the amounts they invest in such activity limits credit provision, why should we believe there are enough risk-loving wealthy people nowadays to support the enormous credit demands of our national and global economies? To use a more limited example, why should we believe there are enough wealthy investment bankers eager and willing to support the capital requirements of ten mini-Goldman Sachs, each with one tenth the assets of the Vampire Squid? More importantly, where are the wealthy commercial and retail bankers eager and willing to support the lending activity of 1,000 mini-JP Morgans, each with one one-thousandth the assets of the House of Dimon? Certainly one can imagine there are lots of retail depositors and wholesale creditors who would be eager to lend to such personally backstopped institutions, but why would a shareholder with potentially unlimited liability—to the extent of her entire personal and family net worth—be remotely interested in borrowing ten times her equity in order to earn 12% on her money?

Hedge funds cannot fill the gap, either: they manage other people’s money. Why would those other people—mostly institutional investors like pension funds, insurance companies, university endowments, and the like—be remotely interested in assuming unlimited liability? For one thing, it would violate their own fiduciary duty: for the most part, it’s not their money, either. It’s firefighters’, teachers’, and pensioners’ money. Do you really think those people want to take unlimited risk? As Steve Waldman says, those people want safety.

Certainly there is a good argument for aligning the payouts and incentives of persons who engage in risky activities more closely with outcomes. It is a noble and desireable objective to undo the privatization of returns and the socialization of risk that we find ourselves plagued with nowadays. But I worry that those who argue for a wholesale return to unlimited liability for the owners of financial intermediaries simply have not thought out the problem of scale inherent in the current global economy.

Plus, I thought we all agreed we don’t like being under the thumb of the very rich. Do we really want to go back to Potter’s Falls?

Related reading:
Carolyn Sissoko, In defense of banking... (Synthetic Assets, January 30, 2012)
Andrew Haldane, Control rights (and wrongs) (The Bank of England, October 24, 2011)

© 2012 The Epicurean Dealmaker. All rights reserved.